The Vanguard press release is dated October 11, 2011, but the story broke on Reuters recently. In anticipation of the DOL’s new Fee Disclosure Rule, there’s been a trend among major investment houses to repackage 401k offerings into “low-cost” bundled options. These products generally combine a variety of services under one umbrella fee. “The solutions both Vanguard and Schwab are rolling out are long overdue,” says Jonathan Leidy, a principal at Portico Wealth Advisors in Larkspur, CA.

Now nearly five months old, Vanguard works with Ascensus to offer its service both directly to plans and through 401k advisers. Some advisers like Vanguard’s initiative into this arena because it will draw more attention to fees. Leidy especially likes the Vanguard product, whose target market is the $0-20MM sized plan. “It provides a relatively low-cost, high-quality platform versus the prevalent insurance wrap products,” he says. Leidy feels “that particular market segment is both grossly underserved and oft exploited.” Michele Suriano, President of Castle Rock Investment Company in Castle Rock, CO, serves clients on both Vanguard’s bundled platform and on the Ascensus platform. She says, “I am delighted they are working together to serve the under $20MM market. They have been working together for years developing this product and the internal record keeping credit from the Vanguard investments makes this solution stand out in the small market.”

The fact Vanguard’s press release and the Reuters story headlined a hypothetical example where at $5,000,000 plan with 100 participants would result in an “all-in” fee of “32 basis points” certainly attracted a lot of attention. Leidy, though, analyzed the example in the press released and discovered revenue sharing accounted for 10 basis points. “In actuality the fee is 42bps,” he points out. “If a sponsor/advisor were to select Admiralty/Signal shares, additional ‘out-of-pocket recordkeeping fees’ would apply,” he says. Leidy estimates once you add in fiduciary adviser fees and individual participant adviser fees (he says these to be in the neighborhood of 1% for small 401k plans), total costs are likely to be similar to other non-bundled providers. Still, he feels these fees remain well below the highest bundled service providers.

The larger question is Vanguard’s casual acceptance of revenue sharing to give the impression of lower fees. While Vanguard is certainly not the only major player to use revenue sharing, this disappoints Leidy. He says, “This sales tactic of ‘eliminating’ fees through revenue sharing has dominated industry fee proposals for decades… I have come to expect this sort of brinkmanship from the Hancocks and Prudentials of the world, but it is disheartening to see Vanguard using the same opaque methods.”

The reliance on revenue sharing, a sore subject with those heeding to a strict fiduciary adherence, is ironic given the 2012 John Bogle Legacy Forum, where Bogle himself said “there’s a crying need for a fiduciary standard.” By lauding a “low-cost” product where that “low-cost” is predicated on revenue sharing, Vanguard risks exposing 401k plan sponsors to increased fiduciary liability. The problem, as Dr. Ron Rhoades so aptly puts it, resides in the conflict of interest borne by wearing two hats, a common situation with bundled service providers. In this case we actually have three hats as Vanguard manages the underlying funds, holds custody of the assets and provides the recordkeeping (albeit through a third party contractor).

Harold Evensky, President of Evensky & Katz understands the attraction to revenue sharing but warns plan sponsors – and their participating employees – to enter these relationships with eyes wide open. He says, “Well disclosed revenue sharing may be acceptable but it’s a slippery slope and to suggest ‘it keeps fees low’ is misleading. It only keeps fees low because the participants end up covering some of the costs. Again, if they understand that, it may be acceptable but the total cost is still the same (or, when hidden, typically higher).”

In a pure fiduciary setting, revenue sharing would have no bearing on investment decisions. Janice J. Sackley, CFE of Fiduciary Foresight says, “Selection of fund menus should be done without regard for whether or not an advisory firm shares in revenue. In an ideal world it is best if the advisory personnel who perform the due diligence on funds for selection on a 401k menu have no knowledge of which funds may provide revenue sharing. Their robust vetting process likely includes performance, fees, stability, error rates, administrative capacity, and many other factors, but [revenue sharing] should not be in the equation. If revenue-sharing funds are selected and the advisor chooses to accept compensation or reimbursement for certain shareholder accounting functions, of course that will trigger the disclosure requirements as well as sign-off by another plan fiduciary. This firewall between the ‘fund selectors’ and the personnel who administer revenue sharing is very difficult to maintain in small firms.”

And revenue sharing does appear to come with a long term cost. Academic research shows “broker-sold” funds – mutual funds that offer commissions, 12b-1 fees and other revenue sharing arrangement – lag “direct-buy” funds on average about 1% per year. One of the authors of the original research, Jonathan Reuter, Assistant Professor of Finance at Boston College’s Carroll School of has a new paper coming out later this year that revisits the data. He’s told FiduciaryNews.com “Our conclusion about actively-managed direct-sold funds outperforming actively managed broker-sold funds is unchanged.” In the face of this research, and the fact uneven revenue sharing among different plan options may have some participants subsidize other participants, 401k plan sponsors will need to examine whether any value associated with revenue sharing will offset the increase in fiduciary liability.

“A 401K plan can certainly avoid the problem by insisting on no sharing with all of the savings being passed on to the participants,” says Evensky.

Vanguard defends its use of revenue sharing. Linda Wolohan, a Vanguard public relations official, says “Any revenue-sharing payments Vanguard may receive from third-party mutual funds are credited back to the plan and can be used to pay for certain eligible ERISA expenses. Any remaining amounts would be distributed to plan participants at year-end.”

At the very least Vanguard’s product and other similar products espousing to be “low-cost” brings the issue to the forefront, and just in time for the implementation of the DOL’s new Fee Disclosure Rule. Many won’t be surprised if plan participants suffer “sticker shock” once they see the fees they’re paying.

Suriano provides a good summary. She says, “During this time of fee compression and disclosures it seems reasonable that all consultants and plan sponsors in the small market should take time to research this solution. It’s important for fiduciaries to have fact based answers when participants start asking how their fees compare to the marketplace and the value provided by their current provider. There will never be a one-size-fits-all solution but it’s our responsibility to align solutions with employer needs so I would encourage fiduciaries to do their research on this product.”

Very insightful analysis here, Chris. I have been wise to Vanguard’s use of non-Admiral/Signal/Inst’l shares on their own platform and have perceived the use of retail shares to be less than “fee neutral”. Your shining light on this is helpful, along with pointing out that the product may not be much less costly compared to other bundled providers when services to plan sponsor and participants are dialed up.

Simply stated, what Mr. Leidy describes as “revenue sharing” is actually Vanguard’s system of attributing a portion of the expense ratio (currently 10 basis points) of the Investor share class of Vanguard funds in plans that we recordkeep to the recordkeeping and administrative services that we provide. These credits are used to offset the cost of those services and they are clearly disclosed. They do not represent an additional payment above the expense ratio of the Investor share class funds. In the example you have used, using the lowest-cost share classes would yield an all-in fee that is 33bps—not the 42bps cited in the article.

To explain how that works, here’s some additional background. Historically, Investor Shares of Vanguard funds have been the primary share class used by our full-service recordkeeping clients. This is because many of our plan sponsors had elected to have their plans pay for recordkeeping services through asset-based fee structures, and that’s still primarily the case today. However, because some plan sponsors wanted to move to fixed out-of-pocket fee structures, we now provide sponsors and their committees with increased flexibility in determining how their plans pay for services. We have simplified our eligibility criteria so that all plans have access to lower-cost share classes, which for our 401k service for small businesses are Signal Shares for Vanguard index funds and Admiral Shares for active funds. The share class that a sponsor chooses does not impact a plan’s all-in fee; it simply provides flexibility in how a plan pays for recordkeeping services.

If a plan uses Investor Shares, it receives credits toward recordkeeping costs. Conversely, plans using the lower expense ratios of Signal and Admiral share classes don’t receive a credit toward the cost of recordkeeping and so an out-of-pocket hard-dollar charge—either paid by the participant or by the sponsor—is necessary to cover the cost of recordkeeping and other services. As a result, plans can choose to pay for plan services among the following structures:
1) Through asset-based fees.
2) Through direct participant- or sponsor-paid fees.
3) Through a combination of asset-based and direct fees.

Again, regardless of the structure the client chooses, the all-in-fee of your example would be 33 bps, not 42 bps. The primary difference is based on how those fees are paid.

Article: The larger question is Vanguard’s casual acceptance of revenue sharing to give the impression of lower fees… AND… By lauding a “low-cost” product where that “low-cost” is predicated on revenue sharing, Vanguard risks exposing 401k plan sponsors to increased fiduciary liability.

Once more, Vanguard’s recordkeeping credits are not revenue sharing. They are used to offset the cost of the administrative services that we provide when sponsors choose to use Vanguard Investor share class funds. Furthermore, the use of recordkeeping credits does not materially impact a plan’s all-in fee—it simply provides clearly disclosed flexibility to sponsors. The credit cannot be used by sponsors to pay third parties or financial advisors. It may only be used to reduce the annual out-of-pocket plan fee and participant fee. In instances that Vanguard receives revenue sharing from non-Vanguard fund companies, it is applied toward the cost of recordkeeping the plan. Vanguard always discloses these amounts to plan sponsors.

As you may know, historically there has not been a requirement to disclose revenue sharing payments—and won’t be until Department of Labor regulations become effective later this year—so some plan sponsors may still be unaware that their explicit recordkeeping fee is being highly subsidized by payments from third parties. In contrast, even in the absence of a regulatory disclosure requirement, Vanguard has long proactively and routinely disclosed plan fees in a comprehensive manner. This includes our all-in fee disclosure, which we began using in the late 1990s.

To reiterate, plans will have approximately the same all-in fees whether the plan uses the lowest-cost shares available or our already low-cost Investor Shares, with any slight variation depending on the funds offered in the plan line-up.

Because of Vanguard’s transparent approach on how revenue sharing is applied, plan sponsors are fully aware of all fees and how the cost impacts their participants, which helps them fulfill their fiduciary obligations of determining the reasonableness of plan fees.

1. Vanguard’s offering, as stated in the article, stands head-and-shoulders above the bulk of the competitors in the $0-20MM space.
2. In a world where expense control is paramount, Vanguard’s platform affords sponsors a reasonably transparent opportunity to exert leverage.
3. As fiduciary consultants to retirement plan sponsors, we are big Vanguard devotees and use their funds copiously when building sponsor menus.
4. I realize this article is roughly a month old, and hence maybe “old news” to everyone, but it has unfortunately taken me this long to plug back into it.

Those things aside, I appreciate Linda’s comments above and by no means was attempting to blast Vanguard with my commentary. I was simply trying to point out the following:

1. Whether you call it revenue sharing or not, the concept is the same. Revenue is collected by the fund company and is subsequently redirected to offset administrative expenses associated with the plan.
2. Although this is a ubiquitous practice in the retirement plan industry (and it is completely acknowledged that sponsors can elect the more transparent Admiral/Signal options), I find the whole notion of fee credits to be inherently less than transparent and, in turn, somewhat odious.
3. From a pure business perspective, I don’t fault Vanguard for being in the fee credit game. It’s likely that a lot of revenue would be left on the table, if they didn’t offer fee credit opportunities. However, taking a hard-line stance against revenue sharing (and any other closely related practices) would be both in the best interest of participants/sponsors, in my opinion, as well as in keeping with the moniker Vanguard.
4. Admittedly devoid of all the facts, I still question the math engendered in the Vanguard brochure. It appears that Vanguard has selected the absolute lowest cost example possible, which, although not unscrupulous, may not be a reasonable portrait of the cost engendered in providing a plan to the average plan sponsor. Specifically, if a plan sponsor were to select any active funds, Vanguard or otherwise, the costs would rise. Similarly (and I am extrapolating here), it seems unlikely that Vanguard would, as an example, be willing to record keep the same $5MM plan cited in the example for 10bps, if the sponsor were to have 1,500 participants instead of the referenced 100.
5. Fee credits breed cross-subsidization… period. In this way, I suppose we are more apostles of “fee purity” as compared to the recently-popularized (and equally noteworthy) notion of “fee transparency.”

That’s all. Linda and Vanguard, please take no offense. In a cupboard of largely rotten vittles, you are indisputable “good eggs.”

Categories

Search

Disclaimer

The materials at this web site are maintained for the sole purpose of providing general information about fiduciary law, tax accounting and investments and do not under any circumstances constitute legal, accounting or investment advice. You should not act or refrain from acting based on these materials without first obtaining the advice of an appropriate professional. Please carefully read the terms and conditions for using this site. This website contains links to third-party websites. We are not responsible for, and make no representations or endorsements with respect to, third-party websites, or with respect to any information, products or services that may be provided by or through such websites.